U.S. suit against Standard & Poor’s raises stakes for Wall Street

The Justice Department’s filing of a multi-billion-dollar fraud lawsuit against the Standard & Poor’s rating agency this week culminates a massive, multi-year federal investigation code-named “Alchemy,” but it’s only the start of a more public legal battle joined by at least 16 state attorneys general.

The outcome could make or break the reputation of the world’s largest credit-rating agency. It will shed additional light on how credit-rating agencies contributed to the nation’s financial near-meltdown in 2008. It also might test the limits of free speech. At the very least, it will keep lawyers busy for a long time.

“Put simply, this alleged conduct is egregious, and it goes to the very heart of the recent financial crisis,” Attorney General Eric Holder declared Tuesday.

The federal lawsuit filed against the firm formally known as Standard & Poor’s Financial Services, along with its parent company, McGraw-Hill, alleges that the firm defrauded investors by issuing inflated ratings for risky mortgage-backed securities that misrepresented the true credit risks.

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The suit further alleges that S&P falsely told investors that its credit ratings were objective and not influenced by potential conflicts of interest, namely that it had compromised its ratings to accommodate Wall Street banks.

Credit-rating agencies serve as a crucial backstop to the U.S. financial system. They provide investors, large and small, a signpost in assessing the likelihood of default by a bond issuer, be it a foreign or local government, or a Wall Street bank offering a sophisticated engineered product.

The federal suit alleges that this backstop function by S&P – which touted its gold-plated AAA ratings on mortgage securities as signaling that they could withstand another Great Depression – crumbled as the firm pushed for greater market share and higher profits.

Justice Department attorneys spelled out their case in a painstakingly detailed 119-page complaint filed in Los Angeles, replete with seemingly incriminating email quotations and references to individuals such as “senior executive G” and “senior analyst B,” codes that apparently shield the identities of more than a dozen executives who are now cooperating with investigators.

The department served “hundreds of subpoenas” and analyzed “millions of pages of documents,” according to Stuart F. Delery, the head of the Justice Department’s Civil Division.

The suit, which seeks damages of $5 billion or more, alleges that S&P executives repeatedly manipulated and refused to update computer models so that they underplayed the perils of subprime and similar brands of risky mortgage securities. Then in 2006 and 2007, when default rates soared, company executives took steps to withhold the truth from the public while helping Wall Street firms avoid massive losses by unloading billions of dollars more in dicey loans, the suit alleges.

Under the current ratings model, Wall Street banks, rather than investors, pay for the ratings. But in the case of the complex bonds in question, the rating agencies also were paid to help pool the mortgages that would underpin the bonds sold to investors.

They essentially were paid to rate the very instruments they were paid to help create.

In a statement, Standard & Poor’s called the federal case “without legal merit” and “unjustified,” and the company has some track record in fending off legal actions because of First Amendment protections for its credit-rating pronouncements. The company says such protections apply because it simply offers opinions.

“A number of court rulings have dismissed challenges made with 20/20 hindsight to a credit rating agency’s opinions of creditworthiness,” the company noted in a lengthy statement.

Justice Department officials said Standard & Poor’s had given the highest, AAA credit ratings to many complex securities, based largely on bundles of mortgages, even though the company knew by 2006 that the housing sector was crashing.

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“S&P misled investors, including many federally insured financial institutions, causing them to lose billions of dollars,” Holder said. “In reality, the ratings were affected by significant conflicts of interest, and S&P was driven by its desire to increase its profits and market share to favor the interests of insurers over investors.”

Sixteen states – including Idaho, North Carolina and Washington – now have filed their own lawsuits against the credit-rating agency, making many of the same allegations but basing their cases around alleged violations of state law.

Holder and acting Associate Attorney General Tony West skirted questions Tuesday about why they’d brought civil, instead of criminal, charges. Delery noted that the 1989 Financial Institutions Reform, Recovery and Enforcement Act, under which the federal lawsuit was brought, requires only proof “by a preponderance of the evidence,” rather than the higher standard required for criminal cases.

Holder declined to discuss whether the other two main ratings agencies – Moody’s Investors Service and Fitch Ratings – might be facing similar suits.

“I would think that this should be the first of several. I can’t imagine, and don’t believe, that S&P was the only rating agency to be looking the other way,” said Mark Rifkin, a securities litigation expert and partner in the New York law firm of Wolf Haldenstein Adler Freeman & Herz.

As to why the government opted against criminal charges, Rifkin thought the Justice Department “has tried to keep the burden of proof away from the criminal burden of proof of ‘beyond a reasonable doubt.’ It just makes it easier for the government’s case.”

While rating agencies have been remarkably accurate over their long history, their recent problems began around 2000, when Wall Street began pooling debt instruments – such as mortgages, car loans and credit card debt – into complex bonds.

From September 2004 through about October 2007, Standard & Poor’s issued credit ratings on $2.8 trillion worth of residential mortgage-backed securities and nearly $1.2 trillion in more complex deals that included bundles of home loans, the suit says.

Tracing the nearly century-old firm’s role in the subprime mortgage debacle, the suit alleges:

– In early 2004, Joanne Rose, the executive managing director of the firm’s structured finance unit, and Thomas Gillis, who headed the unit’s research and criteria group, wrote colleagues that concerns about the integrity of the ratings criteria should be communicated in person rather than by email if at all practical.

– In May of that year, after an analyst reported that S&P was losing a deal because its ratings were more conservative than Moody’s and Fitch’s were, managers scrapped plans to use a new computer program that would have required investment banks to cushion deals better against potential losses.

– S&P executives ignored their own code of conduct dictating that they avoid conflicts of interest, instead bowing to the demands of investment banks that paid the firm as much as $500,000 to rate a single complex offshore deal, known as a collateralized debt obligation.

– The firm assured investors that it had an “integrated surveillance process” to monitor the performance of mortgage securities, but its ratings analysts didn’t review surveillance results before issuing ratings.

– By 2006, low-level panic permeated S&P as defaults on subprime mortgages rose sharply, including unprecedented defaults in the first six to 10 months of some loans, but the firm muted its reaction while accommodating more deals from investment banks.

– On March 17, 2007, an S&P analyst elicited laughter from colleagues when he circulated a video of himself singing a parody of the Talking Heads’ song “Burning Down the House” that climaxed with the words: “Huge delinquencies hit it now . . . Two-thousand-and-six vintage. Bringing down the house.”